A securities trading mechanism can be thought of as a set of protocols that translate the investors' latent demands into realized prices and quantities. Various automated trading systems are known, which execute so-called “program” trading strategies in response to market movements.
Any trading strategy can be classified as passive or aggressive, or a combination of both. Passive trading strategies rely on the use of limit orders. For instance, if an investor wishes to buy (sell) 1,000 shares of XYZ Company, the investor may specify a maximum (minimum) price at which she is willing to buy (sell). This price is known as the limit price, and the order will remain pending until a counter party agrees to trade shares with her at this price. Typically traders will set the limit price to be at or below the current bid price for buy orders, and at or above the current offer price for sell orders. In these cases, the investor passively waits for the market to move in her favor and for her limit price to be accepted by a counter party. Such an approach gives the trader total control over her execution price, but no control over when, if ever, her order will execute. Thus passive strategies are not consonant with a requirement of immediacy or with a requirement that trading of all shares be completed within a given time “horizon” or period of time.
Market orders (or limit orders with marketable prices, such as a buy order with limit price equal to or above the current ask) are the building blocks of an aggressive strategy. A market order allows the trader to receive an immediate execution, but the trader loses control over the execution price. Large market orders pose a unique problem because there may not be enough interest at the quoted market price to satisfy the complete order size. In this case, the execution may result in substantial market impact: a worsening of the execution price relative to the current quoted market price. For example, the lowest current sell offer for ABC Company may be $10 with 400 shares for sale at that price. A market order to buy 100 shares is likely to execute at $10 exactly, but a larger market order for 10,000 shares may execute at an average price of $10.25, which is significantly higher than the current quote at the time the order was entered. The trader who submits such a market order has paid a substantial premium for the right to execute immediately.
Large institutional investors such as mutual funds, hedge funds, etc. face a dilemma. On the one hand, they are trading large blocks of stock and cannot afford to send large market orders that will result in market impact and inferior execution prices. On the other hand, they require a certain degree of immediacy to complete their trades within a defined time horizon. Thus neither a purely passive or purely aggressive approach is appropriate for institutional traders. This leads them to seek out compromise strategies that use a blended passive-aggressive approach.
One such strategy in the prior art is a pegged order. A pegged order, unlike a conventional limit order, automatically corrects its price according to movements in the quoted price. Typically a pegged buy order would be pegged to the bid, meaning that the order price is automatically adjusted to match the current quoted bid price. As counter parties (sellers) place market orders, those orders will execute first against the orders posted at the bid. By automatically maintaining an order price exactly at the bid, the pegged buy order is staying competitive relative to other passive buyers and therefore increasing the likelihood of an execution at a favorable price. Pegging is particularly useful in liquid stocks and fast-moving markets where quoted prices are continuously changing.
Another blended strategy is the discretion order. Discretion orders are basically just regular limit orders, except that they introduce a second limit price. This second price (called the discretion price) is the price at which the trader is willing to execute a trade aggressively. For example, consider a $10.00-$10.10 market, meaning that the current quoted bid is $10.00 and the current quoted offer or ask is $10.10. A trader issues a buy limit order at $10 with a $10.05 discretion price. This order will function as a normal limit order, posting the shares at $10, giving the order a chance of executing at a favorable $10 price if an aggressive seller agrees to sell at this price. But, if the current quoted offer price should ever fall to $10.05 or less, the order will automatically convert to an aggressive order at $10.05. With a discretion order, the trader maintains all of the benefits of a regular limit order (the ability to control execution price and the possibility of saving 10 cents relative to the likely execution price of a market order) but with an increased likelihood of execution. It is a selectively aggressive strategy in that it trades aggressively only when it is cheapest to do so, i.e. when spreads (the difference between the bid and ask) are narrow.
Pegging and discretion can be combined to make a third blended strategy. For example, our trader could issue a buy order pegged to the bid with a 5 cent discretion range. This automatically adjusts the order price so that it always is equal to the current bid, and also automatically adjusts the discretion price so that it is always five cents above the current bid. Thus the order receives all of the pegging advantages (staying competitive with other passive buyers) with all of the discretion advantages (ability to selectively trade aggressively in order to increase the probability of execution).
One way to think about a pegging-with-discretion strategy is that the order is being traded by two independent trading agents. A passive agent maintains an open limit order and automatically adjusts its limit price to match movements in the market. An aggressive agent watches the width of the spread and trades aggressively whenever the spread is narrow. The passive agent is constantly trying to “earn the spread” by attracting market orders from counter parties. The aggressive agent is waiting for opportunities to “pay the spread” but only when it is least expensive to do so. The discretion range (the distance in cents between the limit price and the discretion price) is a measure of the aggressiveness of the strategy. If the discretion range is 0, then the aggressive agent will never trade a share, while if the discretion range is set very high then most if not all of the order will be traded by the aggressive agent.
The concept of the pegging-with-discretion strategy is potentially quite powerful, but the known embodiments of the pegging-with-discretion strategy have a number of drawbacks. First, a strategy of instantaneously adjusting the order price to match quote changes will contribute to momentum that disadvantages the order. For example, say that the current bid/ask for ABC Company is $10/$10.10. Five buyers may place 1,000 share buy orders each pegged to the current bid. All of these orders thus are displayed with a $10.00 price. If a single day-trader submits a 100 share buy order at a $10.09 price, all five pegged buyers will immediately change their prices to $10.09 to match this new buyer. Any sellers watching the market may observe this sudden shift in demand, and may perceive this to be an indication of strong buying interest, in which case the sellers are likely to shift their asking prices higher accordingly. So a day-trader with a very small order has single-handedly moved the market by almost 1%. Moreover, since all five buyers are pegged to each other's bid price, these pegged buyers will never lower their price, only ratchet it higher.
A second drawback is the danger of a pegged strategy giving itself away. Using the example with the five buyers, anyone paying attention to this market is likely to notice the immediate, correlated movements of the five buyers, and it is not difficult to guess that these buyers are employing pegging strategies. This exposes the pegged strategies to exploitation by sellers. Any time a trader uses a systematic strategy for trading, it is imperative that she avoid tipping off other market participants to her strategy.
A third drawback of a pegging-with-discretion strategy is that discretion is cumbersome for traders to use appropriately. To be used effectively, a discretion range should be based on the current market conditions, the historical average bid-ask spread, and the trader's desired urgency for completing the order. The more stocks an investor is trading simultaneously, the more difficult it is to use discretion effectively since the discretion ranges must be set independently for each stock.
Fourth, the discretion range is static, and cannot respond to real-time changes in urgency. As described above, the discretion range is a measure of the aggressiveness of the strategy. It would be advantageous to adjust this discretion range based on the progress of the trade. Typically, a trader will have some notion of an expected time horizon associated with each trade: the expected time it will take for the market to absorb the full size of the trade, given the desired trading strategy. If a trade is progressing faster than expected, it would make sense to narrow the discretion range (i.e., to reduce the aggressiveness of the strategy), while it makes sense to increase the discretion range in cases where the trade progress is falling behind schedule. Since the known forms of discretion (or pegging-with-discretion) orders use a static discretion range, the only way to adjust the discretion range based on progress would be for the trader to make manual corrections. Again, this is cumbersome, particularly when the trader is working a large number of orders simultaneously.
Finally, the pegging, discretion, and pegging-with-discretion order types implemented by ECNs (Electronic Communication Networks) are fairly inflexible, with very limited ability for investors to tailor the strategies based on their individual trading style.
Thus there exists a need in the art for improvements to the known passive/aggressive blended trading strategies as implemented by the above pegging, discretion, and pegging-with-discretion strategies.